An accounting method is a set of rules used to determine when
income and expenses are reported. Your accounting method includes not only your
overall method of accounting, but also the accounting treatment you use for any
material item.

You choose an accounting method when you file your first tax
return. If you later want to change your accounting method, you must get IRS
approval. See
Change in Accounting Method,
later.

No single accounting method is required of all taxpayers. You
must use a system that clearly reflects your income and expenses and you must
maintain records that will enable you to file a correct return. In addition to
your permanent books of account, you must keep any other records necessary to
support the entries on your books and tax returns.

You must use the same accounting method from year to year. An
accounting method clearly reflects income only if all items of gross income and
expenses are treated the same from year to year.

If you do not regularly use an accounting method that clearly
reflects your income, your income will be refigured under the method that, in
the opinion of the IRS, does clearly reflect your income.

This publication does not discuss special methods of accounting
for certain items of income or expenses. For information on reporting income
using one of the long-term contract methods, see section 460 and its
regulations. The following publications also discuss special methods of
reporting income or expenses.

Generally and except as otherwise required, you can use any combination
of cash, accrual, and special methods of accounting if the combination clearly
reflects your income and you use it consistently. However, the following
restrictions apply.

If an inventory is necessary to account for your income, you
must use an accrual method for purchases and sales. See
Exceptions under
Inventories, later. Generally, you can use the cash method for all other
items of income and expenses. See
Inventories,
later.

If you use the cash method for reporting your income, you
must use the cash method for reporting your expenses.

If you use an accrual method for reporting your expenses,
you must use an accrual method for figuring your income.

Any combination that includes the cash method is treated as
the cash method for purposes of section 448.

You can account for business and personal items using different
accounting methods. For example, you can determine your business income and
expenses under an accrual method, even if you use the cash method to figure
personal items.

If you operate two or more separate and distinct businesses,
you can use a different accounting method for each. No business is separate and
distinct, however, unless a complete and separate set of books and records is
maintained for each business.

Note.If you use different accounting methods to create or shift profits
or losses between businesses (for example, through inventory adjustments, sales,
purchases, or expenses) so that income is not clearly reflected, the businesses
will not be considered separate and distinct.

Most individuals and many small businesses use the cash method
of accounting. Generally, if you produce, purchase, or sell merchandise, you
must keep an inventory and use an accrual method for sales and purchases of
merchandise. See
Inventories for exceptions to this rule.

Under the cash method, you include in your gross income all items
of income you actually or constructively receive during the tax year. If you
receive property and services, you must include their fair market value (FMV) in
income.

Income is constructively received when an amount is credited
to your account or made available to you without restriction. You need not have
possession of it. If you authorize someone to be your agent and receive income
for you, you are considered to have received it when your agent receives it.
Income is not constructively received if your control of its receipt is subject
to substantial restrictions or limitations.

You are a calendar year taxpayer. Your bank credited, and made
available, interest to your bank account in December 2007. You neither withdraw
it nor enter it into your books until 2008. You must include the amount in gross
income for 2007, the year that you constructively received it.

You cannot hold checks or postpone taking possession of similar
property from one tax year to another to postpone paying tax on the income. You
must report the income in the year the property is received or made available to
you without restriction.

Under the cash method, generally, you deduct expenses in the
tax year in which you actually pay them. This includes business expenses for
which you contest liability. However, you may not be able to deduct an expense
paid in advance. Instead, you may be required to capitalize certain costs, as
explained later under
Uniform Capitalization Rules.

An expense you pay in advance is deductible only in the year
to which it applies, unless the expense qualifies for the 12-month rule.

Under the 12-month rule, a taxpayer is not required to capitalize
amounts paid to create certain rights or benefits for the taxpayer that do not
extend beyond the earlier of the following.

12 months after the right or benefit begins, or

The end of the tax year after the tax year in which payment
is made.

If you have not been applying the general rule (an expense paid
in advance is deductible only in the year to which it applies) and/or the
12-month rule to the expenses you paid in advance, you must obtain approval from
the IRS before using the general rule and/or the 12-month rule. See
Change in Accounting Method, later.

You are a calendar year taxpayer and pay $3,000 in 2007 for a
business insurance policy that is effective for three years (36 months),
beginning on July 1, 2007. The general rule that an expense paid in advance is
deductible only in the year to which it applies is applicable to this payment
because the payment does not qualify for the 12-month rule. Therefore, only $500
(6/36 x $3,000) is deductible in 2007, $1,000 (12/36 x $3,000) is deductible in
2008, $1,000 (12/36 x $3,000) is deductible in 2009, and the remaining $500 is
deductible in 2010.

You are a calendar year taxpayer and pay $10,000 on July 1, 2007,
for a business insurance policy that is effective for only one year beginning on
July 1, 2007. The 12-month rule applies. Therefore, the full $10,000 is
deductible in 2007.

A corporation or partnership, other than a tax shelter, that
meets the gross receipts test can generally use the cash method. A corporation
or a partnership meets the test if, for each prior tax year beginning after
1985, its average annual gross receipts are $5 million or less.

An entity's average annual gross receipts for a prior tax year is determined by:

Adding the gross receipts for that tax year and the 2 preceding
tax years; and

Dividing the total by 3.

See
Gross receipts test for qualifying taxpayers,
for more information. Generally, a partnership applies the test at the
partnership level. Gross receipts for a short tax year are annualized.

Organizations that are members of an affiliated service group
or a controlled group of corporations treated as a single employer for tax
purposes are required to aggregate their gross receipts to determine whether the
gross receipts test is met.

A corporation or partnership that fails to meet the gross receipts
test for any tax year is prohibited from using the cash method and must change
to an accrual method of accounting, effective for the tax year in which the
entity fails to meet this test.

Generally, a taxpayer engaged in the trade or business of farming
is allowed to use the cash method for its farming business. However, certain
corporations (other than S corporations) and partnerships that have a partner
that is a corporation must use an accrual method for their farming business. For
this purpose, farming does not include the operation of a nursery or sod farm or
the raising or harvesting of trees (other than fruit and nut trees).

There is an exception to the requirement to use an accrual method
for corporations with gross receipts of $1 million or less for each prior tax
year after 1975. For family corporations (defined in section 447(d)(2)(C))
engaged in farming, the exception applies if gross receipts were $25 million or
less for each prior tax year after 1985. See section 447 and chapter 2 of
Publication 225,
Farmer's Tax Guide, for more information.

A corporation meets the function test if at least 95% of its
activities are in the performance of services in the fields of health,
veterinary services, law, engineering (including surveying and mapping),
architecture, accounting, actuarial science, performing arts, or consulting.

A corporation meets the ownership test if at least 95% of its
stock is owned, directly or indirectly, at all times during the year by one or
more of the following.

Employees performing services for the corporation in a field
qualifying under the function test.

Retired employees who had performed services in those fields.

The estate of an employee described in (1) or (2).

Any other person who acquired the stock by reason of the death
of an employee referred to in (1) or (2), but only for the 2-year period
beginning on the date of death.

Indirect ownership is generally taken into account if the stock
is owned indirectly through one or more partnerships, S corporations, or
qualified PSCs. Stock owned by one of these entities is considered owned by the
entity's owners in proportion to their ownership interest in that entity. Other
forms of indirect stock ownership, such as stock owned by family members, are
generally not considered when determining if the ownership test is met.

For purposes of the ownership test, a person is not considered
an employee of a corporation unless that person performs more than minimal
services for the corporation.

A corporation that fails to meet the function test for any tax
year; or fails to meet the ownership test at any time during any tax year must
change to an accrual method of accounting, effective for the year in which the
corporation fails to meet either test. A corporation that fails to meet the
function test or the ownership test is not treated as a qualified PSC for any
part of that tax year.

Under an accrual method of accounting, generally you report income
in the year earned and deduct or capitalize expenses in the year incurred. The
purpose of an accrual method of accounting is to match income and expenses in
the correct year.

Generally, you include an amount as gross income for the tax
year in which all events that fix your right to receive the income have occurred
and you can determine the amount with reasonable accuracy. Under this rule, you
report an amount in your gross income on the earliest of the following dates.

If you perform services for a basic rate specified in a contract,
you must accrue the income at the basic rate, even if you agree to receive
payments at a reduced rate. Continue this procedure until you complete the
services, then account for the difference.

Generally, you report an advance payment for services to be performed
in a later tax year as income in the year you receive the payment. However, if
you receive an advance payment for services you agree to perform by the end of
the next tax year, you can elect to postpone including the advance payment in
income until the next tax year. However, you cannot postpone including any
payment beyond that tax year.

You can postpone reporting income from an advance payment you
receive for a service agreement on property you sell, lease, build, install, or
construct. This includes an agreement providing for incidental replacement of
parts or materials. However, this applies only if you offer the property without
a service agreement in the normal course of business.

You manufacture, sell, and service computers. You received payment
in 2007 for a one-year contingent service contract on a computer you sold. You
can postpone including in income the part of the payment you did not earn in
2007 if, in the normal course of your business, you offer computers for sale
without a contingent service contract.

You are in the television repair business. You received payments
in 2007 for one-year contracts under which you agree to repair or replace
certain parts that fail to function properly in television sets manufactured and
sold by unrelated parties. You include the payments in gross income as you earn
them.

In
Examples 3 and 4,
if you do not perform part of the services by the end of the
following tax year (2008), you must still include advance payments for the
unperformed services in gross income for 2007.

You own a dance studio. On October 1, 2007, you receive payment
for a one-year contract for 48 one-hour lessons beginning on that date. You give
eight lessons in 2007. Under this method of including advance payments, you must
include one-sixth (8/48) of the payment in income for 2007, and five-sixths
(40/48) of the payment in 2008, even if you do not give all the lessons by the
end of 2008.

Assume the same facts as in
Example 3,
except the payment is for a two-year contract for 96 lessons.
You must include the entire payment in income in 2007 since part of the services
may be performed after the following year.

You cannot postpone reporting income from prepaid rent. Prepaid
rent does not include payment for the use of a room or other space when
significant service is also provided for the occupant. You provide significant
service when you supply space in a hotel, boarding house, tourist home, motor
court, motel, or apartment house that furnishes hotel services.

Any advance payment you include in gross receipts on your tax
return for the year you receive payment must not be less than the payment you
include in income for financial reports under the method of accounting used for
those reports. Financial reports include reports to shareholders, partners,
beneficiaries, and other proprietors for credit purposes and consolidated
financial statements.

Special rules apply to including income from advance payments
on agreements for future sales or other dispositions of goods held primarily for
sale to customers in the ordinary course of your trade or business. However, the
rules do not apply to a payment (or part of a payment) for services that are not
an integral part of the main activities covered under the agreement. An
agreement includes a gift certificate that can be redeemed for goods. Amounts
due and payable are considered received.

Under the alternative method, generally include an advance payment
in income in the earlier tax year in which you:

Include advance payments in gross receipts under the method
of accounting you use for tax purposes, or

Include any part of advance payments in income for financial
reports under the method of accounting used for those reports. Financial reports
include reports to shareholders, partners, beneficiaries, and other proprietors
for credit purposes and consolidated financial statements.

You are a retailer. You use an accrual method of accounting and
account for the sale of goods when you ship the goods. You use this method for
both tax and financial reporting purposes. You can include advance payments in
gross receipts for tax purposes in either:
(a) the tax year in which you receive the payments; or
(b) the tax year in which you ship the goods. However, see
Exception for inventory goods,
later.

You are a calendar year taxpayer. You manufacture household furniture
and use an accrual method of accounting. Under this method, you accrue income
for your financial reports when you ship the furniture. For tax purposes, you do
not accrue income until the furniture has been delivered and accepted.

In 2007, you received an advance payment of $8,000 for an order
of furniture to be manufactured for a total price of $20,000. You shipped the
furniture to the customer in December 2007, but it was not delivered and
accepted until January 2008. For tax purposes, you include the $8,000 advance
payment in gross income for 2007; and include the remaining $12,000 of the
contract price in gross income for 2008.

If you have an agreement to sell goods properly included in inventory,
you can postpone including the advance payment in income until the end of the
second tax year following the year you receive an advance payment if, on the
last day of the tax year, you meet the following requirements.

You account for the advance payment under the alternative
method (discussed earlier).

You have received a substantial advance payment on the agreement
(discussed next).

You have enough substantially similar goods on hand, or available
through your normal source of supply, to satisfy the agreement.

These rules also apply to an agreement, such as a gift certificate,
that can be satisfied with goods that cannot be identified in the tax year you
receive an advance payment.

If you meet these conditions, all advance payments you receive
by the end of the second tax year, including payments received in prior years
but not reported, must be included in income by the second tax year following
the tax year of receipt of substantial advance payments. You must also deduct in
that second year all actual or estimated costs for the goods required to satisfy
the agreement. If you estimated the cost, you must take into account any
difference between the estimate and the actual cost when the goods are
delivered.

Note.You must report any advance payments you receive after the second
year in the year received. No further deferral is allowed.

Under an agreement for a future sale, you have substantial advance
payments if, by the end of the tax year, the total advance payments received
during that year and preceding tax years are equal to or more than the total
costs reasonably estimated to be includible in inventory because of the
agreement.

You are a calendar year, accrual method taxpayer who accounts
for advance payments under the alternative method. In 2004, you entered into a
contract for the sale of goods properly includible in your inventory. The total
contract price is $50,000 and you estimate that your total inventoriable costs
for the goods will be $25,000. You receive the following advance payments under
the contract.

2004

$17,500

2005

10,000

2006

7,500

2007

5,000

2008

5,000

2009

5,000

Total contract price

$50,000

Your customer asked you to deliver the goods in 2010. In your
2005 closing inventory, you had on hand enough of the type of goods specified in
the contract to satisfy the contract. Since the advance payments you had
received by the end of 2005 were more than the costs you estimated, the payments
are substantial advance payments.

Include in income for 2007 all payments you receive by the end
of 2007, the second tax year following the tax year in which you received
substantial advance payments. You must include $40,000 in sales for 2007 (the
total amounts received from 2004 through 2007) and include in inventory the cost
of the goods (or similar goods) on hand. If no such goods are on hand, then
estimate the cost necessary to satisfy the contract.

No further deferral is allowed. You must include in gross income
the advance payment you receive each remaining year of the contract. Take into
account the difference between any estimated cost of goods sold and the actual
cost when you deliver the goods in 2010.

Generally, you cannot deduct or capitalize a business expense
until economic performance occurs. If your expense is for property or services
provided to you, or for your use of property, economic performance occurs as the
property or services are provided or the property is used. If your expense is
for property or services you provide to others, economic performance occurs as
you provide the property or services.

You are a calendar year taxpayer. You buy office supplies in
December 2007. You receive the supplies and the bill in December, but you pay
the bill in January 2008. You can deduct the expense in 2007 because all events
have occurred to fix the fact of liability, the liability can be determined, and
economic performance occurred in 2007.

Your office supplies may qualify as a recurring item, discussed
later. If so, you can deduct them in 2007, even if the supplies are not
delivered until 2008 (when economic performance occurs).

If you are required to make payments under workers' compensation
laws or in satisfaction of any tort liability, economic performance occurs as
you make the payments. If you are required to make payments to a special
designated settlement fund established by court order for a tort liability,
economic performance occurs as you make the payments.

Economic performance generally occurs as estimated income tax,
property taxes, employment taxes, etc. are paid. However, you can elect to treat
taxes as a recurring item, discussed later. You can also elect to ratably accrue
real estate taxes. See chapter 5 of Publication 535 for information about real
estate taxes.

Other liabilities for which economic performance occurs as you
make payments include liabilities for breach of contract (to the extent of
incidental, consequential, and liquidated damages), violation of law, rebates
and refunds, awards, prizes, jackpots, insurance, and warranty and service
contracts.

Generally, economic performance occurs as an employee renders
service to the employer. However, deductions for compensation or other benefits
paid to an employee in a year subsequent to economic performance are subject to
the rules governing deferred compensation, deferred benefits, and funded welfare
benefit plans. For information on employee benefit programs, see Publication
15-B, Employer's Tax Guide to Fringe Benefits.

You can take a current deduction for vacation pay earned by your
employees if you pay it during the year or, if the amount is vested, within 21/2
months after the end of the year. If you pay it later than this, you must deduct
it in the year actually paid. An amount is vested if your right to it cannot be
nullified or cancelled.

An exception to the economic performance rule allows certain
recurring items to be treated as incurred during the tax year even though
economic performance has not occurred. The exception applies if all the
following requirements are met.

The all-events test, discussed earlier, is met.

Economic performance occurs by the earlier of the following
dates.

81/2 months after the close of the year.

The date you file a timely return (including extensions)
for the year.

The item is recurring in nature and you consistently treat
similar items as incurred in the tax year in which the all-events test is met.

Either:

The item is not material, or

Accruing the item in the year in which the all-events test
is met results in a better match against income than accruing the item in the
year of economic performance.

This exception does not apply to workers' compensation or tort
liabilities.

You may be able to file an amended return and treat a liability
as incurred under the recurring item exception. You can do so if economic
performance for the liability occurs after you file your tax return for the
year, but within 81/2 months after the close of the tax year.

To determine whether an item is recurring and consistently reported,
consider the frequency with which the item and similar items are incurred (or
expected to be incurred) and how you report these items for tax purposes. A new
expense or an expense not incurred every year can be treated as recurring if it
is reasonable to expect that it will be incurred regularly in the future.

Factors to consider in determining the materiality of a recurring
item include the size of the item (both in absolute terms and in relation to
your income and other expenses) and the treatment of the item on your financial
statements.

An item considered material for financial statement purposes
is also considered material for tax purposes. However, in certain situations an
immaterial item for financial accounting purposes is treated as material for
purposes of economic performance.

Costs directly associated with the revenue of a period are properly
allocable to that period. To determine whether the accrual of an expense in a
particular year results in a better match with the income to which it relates,
generally accepted accounting principles (GAAP; visit
www.fasab.gov/accepted.html) are an important factor.

For example, if you report sales income in the year of sale,
but you do not ship the goods until the following year, the shipping costs are
more properly matched to income in the year of sale than the year the goods are
shipped. Expenses that cannot be practically associated with income of a
particular period, such as advertising costs, should be assigned to the period
the costs are incurred. However, the matching requirement is considered met for
certain types of expenses. These expenses include taxes, payments under
insurance, warranty, and service contracts, rebates, refunds, awards, prizes,
and jackpots.

An expense you pay in advance is deductible only in the year
to which it applies, unless the expense qualifies for the 12-month rule. Under
the 12-month rule, a taxpayer is not required to capitalize amounts paid to
create certain rights or benefits for the taxpayer that do not extend beyond the
earlier of the following.

12 months after the right or benefit begins, or

The end of the tax year after the tax year in which payment
is made.

If you have not been applying the general rule (an expense paid
in advance is deductible only in the year to which it applies) and/or the
12-month rule to the expenses you paid in advance, you must get IRS approval
before using the general rule and/or the 12-month rule. See
Change in Accounting Method, later, for information on how to get IRS approval. See
Expense paid in advance under
Cash Method, earlier, for examples illustrating the application of the
general and 12-month rules.

Business expenses and interest owed to a related person who uses
the cash method of accounting are not deductible until you make the payment and
the corresponding amount is includible in the related person's gross income.
Determine the relationship for this rule as of the end of the tax year for which
the expense or interest would otherwise be deductible. See section 267 and
Publication 542, Corporations, for the definition of related person.

An inventory is necessary to clearly show income when the production,
purchase, or sale of merchandise is an income-producing factor. If you must
account for an inventory in your business, you must use an accrual method of
accounting for your purchases and sales. However, see
Exceptions, next. See also
Accrual Method, earlier.

To figure taxable income, you must value your inventory at the
beginning and end of each tax year. To determine the value, you need a method
for identifying the items in your inventory and a method for valuing these
items. See
Identifying Cost
and
Valuing Inventory,
later.

The rules for valuing inventory are not the same for all businesses.
The method you use must conform to generally accepted accounting principles for
similar businesses and must clearly reflect income. Your inventory practices
must be consistent from year to year.

The rules discussed here apply only if they do not conflict
with the uniform capitalization rules of section 263A and the mark-to-market
rules of section 475.

The following taxpayers can use the cash method of accounting
even if they produce, purchase, or sell merchandise. These taxpayers can also
account for inventoriable items as materials and supplies that are not
incidental (discussed later).

A qualifying small business taxpayer under Revenue Procedure
2002-28 in Internal Revenue Bulletin 2002-18.

In addition to the information provided in this publication,
you should see the revenue procedures referenced in the list, above, and the
instructions for Form 3115 for information you will need to adopt or change to
these accounting methods (see Changing methods, later).

You are a qualifying taxpayer under Revenue Procedure 2001-10
only if:

You satisfy the gross receipts test for each prior tax year
ending on or after December 17, 1998 (see
Gross receipts test for qualifying taxpayers, next). Your average annual gross receipts for each test
year (explained in Step 1, listed next) must be $1 million or less.

To determine if you meet the gross receipts test for qualifying
taxpayers, use the following steps:

Step 1.
List each of the test years. For qualifying taxpayers under Revenue Procedure
2001-10, the test years are each prior tax year ending on or after December 17,
1998. For 2007, the test years are 1998, 1999, 2000, 2001, 2002, 2003, 2004,
2005, and 2006 for a calendar year taxpayer.

Step 2.
Determine your average annual gross receipts for each test year listed in Step
1. Your average annual gross receipts for a tax year is determined by adding the
gross receipts for that tax year and the 2 preceding tax years and dividing the
total by 3. For example, if gross receipts are $200,000 for 1998, $800,000 for
1999, and $1,100,000 for 2000, the average annual gross receipts for 2000 are
$700,000 (($200,000 + $800,000 + $1,100,000) ÷ 3 = $700,000). See section 5
of Revenue Procedure 2001-10 for more information.

Step 3.
You meet the gross receipts test for qualifying taxpayers if your average annual
gross receipts for each test year listed in Step 1 is $1 million or less.

You are a qualifying small business taxpayer under Revenue Procedure
2002-28 only if:

You satisfy the gross receipts test for each prior tax year
ending on or after December 31, 2000 (see
Gross receipts test for qualifying small business taxpayers, next). Your average annual gross receipts for each test
year (explained in Step 1, listed next) must be $10 million or less.

You are not prohibited from using the cash method under section
448.

Your principle business activity is an eligible business.
See
Eligible business, later.

You have not changed (or have not been required to change)
from the cash method because you became ineligible to use the cash method under
Revenue Procedure 2002-28.

Note.Revenue Procedure 2002-28 does not apply to a farming business
of a qualifying small business taxpayer. A taxpayer engaged in the trade or
business of farming generally is allowed to use the cash method for any farming
business. See
Special rules for farming businesses under
Cash Method, earlier.

To determine if you meet the gross receipts test for qualifying
small business taxpayers, use the following steps:

Step 1.
List each of the test years. For qualifying small business taxpayers under
Revenue Procedure 2002-28, the test years are each prior tax year ending on or
after December 31, 2000. For 2007, the test years are 2000, 2001, 2002, 2003,
2004, 2005, and 2006 for a calendar year taxpayer.

Step 2.
Determine your average annual gross receipts for each test year listed in Step
1. Your average annual gross receipts for a tax year is determined by adding the
gross receipts for that tax year and the 2 preceding tax years and dividing the
total by 3. For example, if gross receipts are $6 million for 2005, $9 million
for 2006, and $12 million for 2007, the average annual gross receipts for 2007
are $9 million (($6 million + $9 million + $12 million) ÷ 3 = $9 million).
See section 5 of Revenue Procedure 2002-28 for more information.

Step 3.
You meet the gross receipts test for qualifying small business taxpayers if your
average annual gross receipts for each test year listed in Step 1 is $10 million
or less.

An eligible business is any business for which a qualified small
business taxpayer can use the cash method and choose to not keep an inventory.
You have an eligible business if you meet any of the following requirements.

Your principal business activity is described in a North American
Industry Classification System (NAICS) code other than any of the following.

NAICS codes 211 and 212 (mining activities).

NAICS codes 31-33 (manufacturing).

NAICS code 42 (wholesale trade).

NAICS codes 44-45 (retail trade).

NAICS codes 5111 and 5122 (information industries).

Your principal business activity is the provision of services,
including the provision of property incident to those services.

Your principal business activity is the fabrication or modification
of tangible personal property upon demand in accordance with customer design or
specifications.

Information about the NAICS codes can be found at
http://www.census.gov/naics or in the instructions for your federal income tax return.

In general, gross receipts must include all receipts from all
your trades or businesses that must be recognized under the method of accounting
you used for that tax year for federal income tax purposes. See the definition
of gross receipts in Temporary Regulations section 1.448-1T(f)(2)(iv) for
details.

If you did not own your business for all of the 3-tax-year period
used in determining your average annual gross receipts, include the period of
any predecessor. If your business has not been in existence for the 3-tax-year
period, base your average on the period it has existed including any short tax
years, annualizing the short tax year's gross receipts.

If you account for inventoriable items as materials and supplies
that are not incidental, you will deduct the cost of the items you would
otherwise include in inventory in the year you sell the items, or the year you
pay for them, whichever is later. If you are a qualifying taxpayer under Revenue
Procedure 2001-10 and a producer, you can use any reasonable method to estimate
the raw material in your work in process and finished goods on hand at the end
of the year to determine the raw material used to produce finished goods that
were sold during the year. If you are a qualifying small business taxpayer under
Revenue Procedure 2002-28, you must use the specific identification method, the
first-in first-out (FIFO) method, or an average cost method to determine the
amount of your allowable deduction for non-incidental materials and supplies
consumed and used in your business. See section 4.02 in Revenue Procedure
2001-10 or section 4.05 in Revenue Procedure 2002-28 for more information. Also,
see Example 15 and
Example 17 through
Example 20 in section 6 of Revenue Procedure 2002-28.

If you are a qualifying taxpayer or qualifying small business
taxpayer and want to change to the cash method or to account for inventoriable
items as non-incidental materials and supplies, you must file Form 3115. Both
changes can be requested under the automatic change procedures of Revenue
Procedure 2002-9 and 2006-12 in Internal Revenue Bulletins 2002-3 and 2006-3 (or
their successors). For additional guidance, see section 6 of Revenue Procedure
2001-10 for qualifying taxpayers or section 7 of Revenue Procedure 2002-28 for
qualifying small business taxpayers. You can file one Form 3115 if you choose to
request to change to the cash method and to account for inventoriable items as
non-incidental materials and supplies.

If you sell merchandise by mail and intend payment and delivery
to happen at the same time, title passes when payment is made. Include the
merchandise in your closing inventory until the buyer pays for it.

Containers such as kegs, bottles, and cases, regardless of whether
they are on hand or returnable, should be included in inventory if title has not
passed to the buyer of the contents. If title has passed to the buyer, exclude
the containers from inventory. Under certain circumstances, some containers can
be depreciated. See Publication 946.

The FIFO (first-in first-out) method assumes the items you purchased
or produced first are the first items you sold, consumed, or otherwise disposed
of. The items in inventory at the end of the tax year are matched with the costs
of similar items that you most recently purchased or produced.

The LIFO (last-in first-out) method assumes the items of inventory
you purchased or produced last are the first items you sold, consumed, or
otherwise disposed of. Items included in closing inventory are considered to be
from the opening inventory in the order of acquisition and from those acquired
during the tax year.

The rules for using the LIFO method are very complex. Two are
discussed briefly here. For more information on these and other LIFO rules, see
sections 472 through 474 and the corresponding regulations.

Under the dollar-value method of pricing LIFO inventories, goods
and products must be grouped into one or more pools (classes of items),
depending on the kinds of goods or products in the inventories. See section
1.472-8 of the regulations.

Under this method, you establish multiple inventory pools in
general categories from appropriate government price indexes. You then use
changes in the price index to estimate the annual change in price for inventory
items in the pools.

An eligible small business (average annual gross receipts of
$5 million or less for the 3 preceding tax years) can elect the simplified
dollar-value LIFO method.

For more information, see section 474. Taxpayers who cannot use
the method under section 474 should see section 1.472-8(e)(3) of the regulations
for a similar simplified dollar-value method.

File Form 970, Application To Use LIFO Inventory Method, or a
statement with all the information required on Form 970 to adopt the LIFO
method. You must file the form (or the statement) with your timely filed tax
return for the year in which you first use LIFO.

Each method produces different income results, depending on the
trend of price levels at the time. In times of inflation, when prices are
rising, LIFO will produce a larger cost of goods sold and a lower closing
inventory. Under FIFO, the cost of goods sold will be lower and the closing
inventory will be higher. However, in times of falling prices, the opposite will
hold.

These are goods you cannot sell at normal prices or they are
unusable in the usual way because of damage, imperfections, shop wear, changes
of style, odd or broken lots, or other similar causes, including secondhand
goods taken in exchange. You should value these goods at their bona fide selling
price minus direct cost of disposition, no matter which method you use to value
the rest of your inventory. If these goods consist of raw materials or partly
finished goods held for use or consumption, you must value them on a reasonable
basis, considering their usability and condition. Do not value them for less
than scrap value. For more information, see section 1.471-2(c) of the
regulations.

To properly value your inventory at cost, you must include all
direct and indirect costs associated with it. The following rules apply.

For merchandise on hand at the beginning of the tax year,
cost means the ending inventory price of the goods.

For merchandise purchased during the year, cost means the
invoice price minus appropriate discounts plus transportation or other charges
incurred in acquiring the goods. It can also include other costs that have to be
capitalized under the uniform capitalization rules of section 263A.

For merchandise produced during the year, cost means all direct
and indirect costs that have to be capitalized under the uniform capitalization
rules.

A trade discount is a discount allowed regardless of when the
payment is made. Generally, it is for volume or quantity purchases. You must
reduce the cost of inventory by a trade (or quantity) discount.

A cash discount is a reduction in the invoice or purchase price
for paying within a prescribed time period. You can choose either to deduct cash
discounts or include them in income, but you must treat them consistently from
year to year.

Under ordinary circumstances for normal goods, market value means
the usual bid price on the date of inventory. This price is based on the volume
of merchandise you usually buy. For example, if you buy items in small lots at
$10 an item and a competitor buys identical items in larger lots at $8.50 an
item, your usual market price will be higher than your competitor's.

When you offer merchandise for sale at a price lower than market
in the normal course of business, you can value the inventory at the lower
price, minus the direct cost of disposition. Determine these prices from the
actual sales for a reasonable period before and after the date of your
inventory. Prices that vary materially from the actual prices will not be
accepted as reflecting the market.

If no market exists, or if quotations are nominal because of
an inactive market, you must use the best available evidence of fair market
price on the date or dates nearest your inventory date. This evidence could
include the following items.

Specific purchases or sales you or others made in reasonable
volume and in good faith.

Compensation amounts paid for cancellation of contracts for
purchase commitments.

Under the retail method, the total retail selling price of goods
on hand at the end of the tax year in each department or of each class of goods
is reduced to approximate cost by using an average markup expressed as a
percentage of the total retail selling price.

To figure the average markup, apply the following steps in order.

Add the total of the retail selling prices of the goods in
the opening inventory and the retail selling prices of the goods you bought
during the year (adjusted for all markups and markdowns).

Subtract from the total in (1) the cost of goods included
in the opening inventory plus the cost of goods you bought during the year.

Divide the balance in (2) by the total selling price in (1).
The result is the average markup percentage.

Then determine the approximate cost in three steps.

Subtract the sales at retail from the total retail selling
price. The result is the closing inventory at retail.

Multiply the closing inventory at retail by the average markup
percentage. The result is the markup in closing inventory.

Subtract the markup in (2) from the closing inventory at retail.
The result is the approximate closing inventory at cost.

The markup ($35,000) is the difference between cost ($105,000)
and the retail value ($140,000). Divide the markup by the total retail value to
get the markup percentage (25%). You cannot use arbitrary standard percentages
of purchase markup to determine markup. You must determine it as accurately as
possible from department records for the period covered by your tax return.

When determining the retail selling price of goods on hand at
the end of the year, markdowns are recognized only if the goods were offered to
the public at the reduced price. Markdowns not based on an actual reduction of
retail sales price, such as those based on depreciation and obsolescence, are
not allowed.

If you are using the retail method and LIFO, adjust the inventory
value, determined using the retail method, at the end of the year to reflect
price changes since the close of the preceding year. Generally, to make this
adjustment, you must develop your own retail price index based on an analysis of
your own data under a method acceptable to the IRS. However, a department store
using LIFO that offers a full line of merchandise for sale can use an inventory
price index provided by the Bureau of Labor Statistics. Other sellers can use
this index if they can demonstrate the index is accurate, reliable, and suitable
for their use. For more information, see Revenue Ruling 75-181 in Cumulative
Bulletin 1975-1.

If you do not use LIFO and have been determining your inventory
under the retail method except that, to approximate the lower of cost or market,
you have followed the consistent practice of adjusting the retail selling prices
of goods for markups (but not markdowns), you can continue that practice. The
adjustments must be bona fide, consistent, and uniform and you must also exclude
markups made to cancel or correct markdowns. The markups you include must be
reduced by markdowns made to cancel or correct the markups.

If you do not use LIFO and you previously determined inventories
without eliminating markdowns in making adjustments to retail selling prices,
you can continue this practice only if you first get IRS approval. You can adopt
and use this practice on the first tax return you file for the business, subject
to IRS approval on examination of your tax return.

Resellers who use the retail method of pricing inventories can
determine their tax on that basis.

To use this method, you must do all of the following.

State that you are using the retail method on your tax return.

Keep accurate records.

Use this method each year unless the IRS allows you to change
to another method.

You must keep records for each separate department or class of
goods carrying different percentages of gross profit. Purchase records should
show the firm name, date of invoice, invoice cost, and retail selling price. You
should also keep records of the respective departmental or class accumulation of
all purchases, markdowns, sales, stock, etc.

You can figure the cost of goods on hand by either a perpetual
or book inventory if inventory is kept by following sound accounting practices.
Inventory accounts must be charged with the actual cost of goods purchased or
produced and credited with the value of goods used, transferred, or sold.
Credits must be determined on the basis of the actual cost of goods acquired
during the year and their inventory value at the beginning of the tax year.

You claim a casualty or theft loss of inventory, including items
you hold for sale to customers, through the increase in the cost of goods sold
by properly reporting your opening and closing inventories. You cannot claim the
loss again as a casualty or theft loss. Any insurance or other reimbursement you
receive for the loss is taxable.

You can choose to claim the loss separately as a casualty or
theft loss. If you claim the loss separately, adjust opening inventory or
purchases to eliminate the loss items and avoid counting the loss twice.

If you claim the loss separately, reduce the loss by the reimbursement
you receive or expect to receive. If you do not receive the reimbursement by the
end of the year, you cannot claim a loss for any amounts you reasonably expect
to recover.

If your inventory loss is due to a disaster in an area determined
by the President of the United States to be eligible for federal assistance, you
can choose to deduct the loss on your return for the immediately preceding year.
However, you must also decrease your opening inventory for the year of the loss
so the loss will not show up again in inventory.

Under the uniform capitalization rules, you must capitalize the
direct costs and part of the indirect costs for production or resale activities.
Include these costs in the basis of property you produce or acquire for resale,
rather than claiming them as a current deduction. You recover the costs through
depreciation, amortization, or cost of goods sold when you use, sell, or
otherwise dispose of the property.

Special uniform capitalization rules apply to a farming business.
See chapter 6 in Publication 225.

You produce property if you construct, build, install, manufacture,
develop, improve, create, raise, or grow the property. Property produced for you
under a contract is treated as produced by you to the extent you make payments
or otherwise incur costs in connection with the property.

Resellers of personal property with average annual gross receipts
of $10 million or less (small resellers).

Property produced to use as personal or nonbusiness property
or for uses not connected with a trade or business or an activity conducted for
profit.

Research and experimental expenditures deductible under section
174.

Intangible drilling and development costs of oil and gas or
geothermal wells or any amortization deduction allowable under section 59(e) for
intangible drilling, development, or mining exploration expenditures.

Property produced under a long-term contract, except for certain
home construction contracts described in section 460(e)(1).

Timber and certain ornamental trees raised, harvested, or
grown, and the underlying land.

Qualified creative expenses paid or incurred as a free-lance
(self-employed) writer, photographer, or artist that are otherwise deductible on
your tax return.

Costs allocable to natural gas acquired for resale to the
extent these costs would otherwise be allocable to cushion gas stored
underground.

Property produced if substantial construction occurred before
March 1, 1986.

Property provided to customers in connection with providing
services. It must be
de minimus
in amount and not be included in inventory in the hands of the service provider.

Loan origination.

The costs of certain producers who use a simplified production
method and whose total indirect costs are $200,000 or less. See section
1.263A-2(b)(3)(iv) of the regulations for more information.

Qualified creative expenses are expenses paid or incurred by
a free-lance (self-employed) writer, photographer, or artist whose personal
efforts create (or can reasonably be expected to create) certain properties.
These expenses do not include expenses related to printing, photographic plates,
motion picture films, video tapes, or similar items.

These individuals are defined as follows.

A writer is an individual who creates a literary manuscript,
a musical composition (including any accompanying words), or a dance score.

A photographer is an individual who creates a photograph or
photographic negative or transparency.

An artist is an individual who creates a picture, painting,
sculpture, statue, etching, drawing, cartoon, graphic design, or original print
item. The originality and uniqueness of the item created and the predominance of
aesthetic value over utilitarian value of the item created are taken into
account.

The exemption for writers, photographers, and artists also applies
to an expense of a personal service corporation that directly relates to the
activities of the qualified employee-owner. A qualified employee-owner is a
writer, photographer, or artist who owns, with certain members of his or her
family, substantially all the stock of the corporation.

If you must adopt the uniform capitalization rules, revalue the
items or costs included in beginning inventory for the year of change as if the
capitalization rules had been in effect for all prior periods. When revaluing
inventory costs, the capitalization rules apply to all inventory costs
accumulated in prior periods. An adjustment is required under section 481(a). It
is the difference between the original value of the inventory and the revalued
inventory.

If you must capitalize costs for production and resale activities,
you are required to make this change. If you make the change for the first tax
year you are subject to the uniform capitalization rules, it is an automatic
change of accounting method that does not need IRS approval. Otherwise, IRS
approval is required to make the change.

Generally, you can choose any permitted accounting method when
you file your first tax return. You do not need to obtain IRS approval to choose
the initial accounting method. You must, however, use the method consistently
from year to year and it must clearly reflect your income. See
Accounting Methods,
earlier.

Once you have set up your accounting method and filed your first
return, generally, you must receive approval from the IRS before you change the
method. In general, you must file a current Form 3115 to request a change in
either an overall accounting method or the accounting treatment of any item.

A change in your accounting method includes a change not only
in your overall system of accounting but also in the treatment of any material
item. A material item is one that affects the proper time for inclusion of
income or allowance of a deduction. Although an accounting method can exist
without treating an item consistently, an accounting method is not established
for that item, in most cases, unless the item is treated consistently.